In the nearly six years since enactment of the Dodd Frank Act, US bank regulators and banks have obsessively focused on a range of rulemaking, compliance, and control issues. From consumer disclosures, mortgage loan terms, and fair lending, to cybersecurity, corporate governance, and resolution planning, the regulatory focus has been on technical details that were not a central focus for bank regulators in prior years. The Consumer Financial Protection Bureau (CFPB) is the first bank regulator with no stake in the solvency of the institutions it regulates, and is representative of the recent shift in regulatory focus. Excluding higher capital and liquidity requirements and stress-testing, most of the focus has been away from balance sheet risk.
The main thing, however, that decides whether a bank prospers or fails is not consumer disclosures, but the quality of the assets on the bank’s balance sheet. Recent reports and guidance from the Financial Stability Oversight Council (FSOC), the Office of Financial Research (OFR), the Office of the Comptroller of the Currency (OCC), the FDIC, the Federal Reserve Board, and the European Central Bank (ECB) have turned the focus back on bank loan portfolio credit quality and interest rate risk. These fundamental balance sheet risks have reemerged as an area of primary regulatory concern.
The OFR, an economic think tank wing of the US Treasury Department that works closely with FSOC, summed up regulators’ concerns about credit risk in bank loan portfolios in its January 2016 Report to Congress, stating that “threats to US financial stability have edged higher since last year’s report….” According to the OFR:
Three key vulnerabilities stand out: (1) the long-term impact on risk-taking of persistently low interest rates, (2) mounting debt and declining credit quality in U.S. corporations and emerging-market countries, and (3) weaknesses that remain in the system despite financial reforms and better risk management by financial companies
The following Advisory summarizes the risks identified by regulators as associated with persistent low interest rates (and the related risks from potential future increases in rates and the incentive for lenders to seek business and yield by accepting an increase in the risk profile of loan portfolios through decreased credit standards), a decline in credit market liquidity, a decline in credit quality of borrowers, problems in particular sectors including commercial real estate and oil-and-gas related credits, the global economic slowdown and problems in China, emerging markets and Europe, and finally the wild card posed by pending changes to accounting standards to loan loss reserves.
Persistent Low Interest Rates and Reaching for Yield
The current environment has seen a period of nearly six years of loans at historically low rates as the Federal Reserve used “quantitative easing” to help restore the economy. This strategy worked. As the ECB has noted, “[t]he low general level of interest rates contributed most to the increase in loan demand.”
There is, however, a dark side to the Federal Reserve flooding the markets with credit to maintain persistently and artificially low interest rates. The OCC, in releasing its most recent semi-annual report of key risks facing banks, observed that:
- Many national banks and federal savings associations continue to face strategic challenges to growing revenues to meet target rates of return in a slow-growth, low interest rate environment.
- Banks and thrifts are easing credit underwriting standards and practices, including structure, terms, pricing, collateral, guarantors, and loan controls in response to competitive pressures and growth objectives. This easing is particularly evident in high-growth loan segments, such as indirect auto, commercial and industrial, and multifamily. [and]
- The ongoing low interest rate environment poses additional concerns as banks reach for yield by loosening underwriting and extending asset duration trends.
The OFR noted that “[p]ersistently low interest rates and suppressed risk premiums in US fixed-income markets contribute to excessive risk-taking and borrowing that could pose financial stability risks."
The OFR elaborated upon the problems created by persistently low interest rates in its December 2015 Financial Stability Report:
U.S. interest rates remain in a historically low range, which continues to incentivize financial risk-taking and borrowing. Although the Federal Reserve is widely expected to begin raising interest rates imminently, the pace of tightening is expected to be gradual, and long-term interest rates appear to be suppressed by factors that may endure for some time.
Excesses related to the low-interest-rate environment could pose financial stability risks:
- Investors continue to reach for yield, taking on significant duration, volatility, and credit risk.
- Risk premiums in US fixed-income markets are suppressed, raising the potential for rapid and disorderly repricing.
- The low level of interest rates underlies the high level and rapid growth of US nonfinancial business debt and the associated credit risk, as discussed.
The Return of Interest Rate Risk
The S&L crisis of the 1980s was largely the result of a sudden increase in interest rates as the Federal Reserve moved from a policy of managing interest rates to a policy of reducing inflation by allowing rates to rise. Savings and loans were stuck with long-term portfolios of relatively low rate loans, and financing them with high rate deposits. Much of the savings and loan industry, and many commercial banks, were rendered insolvent on a mark-to-market basis by the sudden and large upward movement in interest rates.
At present, interest rates are at historic lows and have nowhere to go but up. As a result, “[t]he sensitivity of bond prices to changes in interest rates (duration risk) is at a historic high.". "[T]hese circumstances leave investors vulnerable to significant losses if interest rates were to spike." And at this moment, after many delays, “the Federal Reserve is beginning to adjust short-term policy rates away from the near zero level of the past seven years." What could possibly go wrong? According to FSOC, “[a] sharp increase in interest rates or credit spreads could generate losses on longer-term assets, including less liquid assets such as high-yield and emerging market bonds. If such losses are borne by leveraged investors, they could lead to fire sales and further declines in asset prices."
Declining Liquidity in Credit Markets
In December 2015, the OCC reported that its national risk committee is “monitoring several risks that … have the potential to develop into broader systemic issues and may already raise concern at individual banks. The risks include … banks’ ability to exit balance-sheet positions because of declining market liquidity."
Lending in a time of shrinking credit liquidity is like a game of musical chairs. While credit is flowing freely, a bank can readily sell a good loan or the borrower can refinance it. But when the music stops, the lender and the borrower are stuck with one another. If the bank needs to raise cash, it may not be able to without a large loss even if the credit is performing. If the borrower wants to move or refinance the credit, it may not be able to do so. And the fundamentals of the business of the borrower and the value of any collateral posted are likely to be worse than in times of flush credit. Declining liquidity in the credit markets tends to feed upon itself and magnify the other risks in the bank’s portfolio.
Weakening Underwriting Standards and Less Protective Credit Terms
Comptroller of the Currency Thomas Curry voiced the OCC’s concerns in remarks in December:
As the economic cycle turns, we see banks and thrifts reaching for yield and growth, sometimes extending their reach at the expense of sound underwriting, strong risk management, and adequate loan loss provisioning. OCC examiners will be paying close attention to each of those areas in the coming months. As I’ve mentioned previously, in the area of credit risk, the warning lights are flashing yellow. Regulators and bank management need to act now to prevent those risks from becoming reality. We can’t afford to wait until the warning lights turn red.
[W]e’ve seen banks and thrifts relax underwriting standards, layer risks in consumer and commercial lending products, and accumulate concentrations, particularly in commercial real estate.
In terms of underwriting, this is the third consecutive year in which we’ve seen underwriting standards slip. Generally, we are seeing banks continue to make concessions on pricing, weaker or non-existent loan covenants, and maturities lengthening. We have also seen increases in underwriting exceptions and risk layering. All of which combine to introduce risk at origination. Bankers with long memories will remember the worst loans are made in the best of times, and the growing credit risk in their banks should be managed very closely.
The FSOC voiced similar concerns regarding increased credit risk-taking by banks in its May 2015 Annual Report. According to the FSOC:
The historically low-yield environment continues to encourage greater risk-taking across the financial system. Investors may seek incremental gains in yield for disproportionate amounts of risk. Banks, credit unions, and broker-dealers have lower net interest margins (NIMs), leading some firms to increase risk by holding longer-duration assets, easing lending standards, or engaging in other forms of increased risk-taking. For example, federal banking agencies have found serious deficiencies in underwriting standards and risk management practices for certain leveraged loans.
The OFR highlighted this risk in its January 2016 report to Congress, stating that“[p]ersistently low rates will continue to prompt investors to take higher risks to increase their returns on investment and may encourage excessive borrowing.
And this is not a uniquely US problem. The ECB indicated in November 2015 that “euro area banks reported a continued net easing of credit standards on loans to enterprises in the fourth quarter of 2015."
The ECB further stated that European “[b]anks continued to ease their terms and conditions on new loans across all categories, mainly driven by a further narrowing of margins on average loans. As with credit standards, the main factor contributing to the easing in terms and conditions was competition.
Declining Credit Quality Among Borrowers and Rising Debt Levels
In the press release accompanying its December 2015 Financial Stability Report, the OFR emphasized areas of particular concern over credit risks:
Credit risks are elevated and rising for U.S. nonfinancial businesses and in many emerging markets. In the U.S., nonfinancial business debt is growing rapidly, boosting leverage; in relation to gross domestic product, it is at a historically elevated level.
In the body of the Financial Stability Report, the OFR elaborated upon its view that elevated and rising credit risks may pose systemic risk. According to the OFR:
Credit risks in the U.S. nonfinancial business sector and emerging markets have been rising for some time. Those risks are now elevated, and likely will continue to rise. U.S. nonfinancial business debt growth continues at a rapid pace, fueled by highly accommodative credit and underwriting standards; the ratio of corporate debt to gross domestic product (GDP) is at a historically elevated level; and firm leverage ratios continue to rise.
So far, distress in U.S. credit markets has been largely limited to the lowest-rated debt issuers and the energy and commodity industries. However, that distress may spread as investors now appear to be reassessing the credit and liquidity risks in these markets. U.S. corporate bond spreads have risen from their narrow 2014 levels toward long-term averages, better compensating investors for some, but by no means all, of the increased credit risk.
Macroeconomic fundamentals, meanwhile, have deteriorated: Slower global growth and lower inflation, a stronger dollar, and the plunge in commodity prices are weakening the debt-service capacity of many U.S. and emerging market borrowers. And many emerging market economies face even more elevated credit risks, with private-sector debt levels at historic highs after years of rapid credit expansion. A shock that significantly further impairs U.S. corporate or emerging market credit quality could potentially threaten U.S. financial stability.
In its January 2016 Annual Report to Congress, the OFR elaborated further:
The ratio of the debt of nonfinancial businesses in the United States to gross domestic product is historically high and companies’ leverage (the ratio of debt to earnings) continues to rise. The hunt for yield and current historically low default rates are promoting easy credit and heavy borrowing.
Today’s low default rates seem unlikely to persist. Stress in energy and commodity industries from declining prices could spread as investors reassess their risks.
* * *
Credit risk, or the risk of borrowers defaulting and failing to repay their debts, is high and rising among nonfinancial U.S. businesses … [D]ebt among nonfinancial companies has been growing for years and is at a historic high relative to U.S. gross domestic product.
The OFR analysis concluded somewhat ominously, “[e]levated debt and sinking earnings are hallmarks of the late stage of the credit cycle, which typically precedes a rise in default rates."]
Commercial Real Estate Loans
Commercial real estate (CRE) loan portfolios are a bell cow that has led many banks to the slaughterhouse. Given their history in bank crises, the federal bank regulators in late 2015 began to raise the alarm over CRE portfolios. In its December 2015 semi-annual report on risks in the banking system, the OCC called attention to “increasing loan concentrations in multifamily CRE…."
The OCC was joined by the FDIC and Federal Reserve shortly thereafter in issuing supervisory guidance on CRE:
[M]any institutions’ CRE concentration levels have been rising. … [A]n easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. The agencies also have observed certain risk management practices at some institutions that cause concern, including a greater number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risks associated with these concentrations….
Necessary elements of risk management identified by the regulators for CRE include: keeping the board and senior management apprised and involved; being aware of changing conditions in the economy, the market segments, the rental market and the borrower; managing concentration risk; and adjusting underwriting standards, reserves, and capital requirements accordingly.
The interagency CRE guidance noted that “financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure." The guidance continued by stating that banks “should review their policies and practices related to CRE lending and … maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk” and noted in particular that banks “should maintain underwriting discipline and exercise prudent risk management practices that identify, measure, monitor, and manage the risks arising from their CRE lending activity."
The interagency CRE guidance concluded with the warning that in 2016, “the banking agencies will … pay special attention to potential risks associated with CRE lending.” The guidance stated that examinations “will focus on financial institutions’ implementation of the prudent principles” and “identifying, measuring, monitoring, and managing concentration risk in CRE lending activities.” The interagency CRE guidance notes that “the agencies will focus on those financial institutions that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals” and stated that they may “ask” banks with “inadequate risk management practices and capital strategies to develop a plan to identify, measure, monitor, and manage CRE concentrations, to reduce risk tolerances in their underwriting standards, or to raise additional capital to mitigate the risk associated with their CRE strategies or exposures."
Oil and Gas-Related Loans
Among the risks that OCC’s national risk committee is “monitoring … that … have the potential to develop into broader systemic issues and may already raise concern at individual banks” is “exposure to oil- and gas-related sectors (e.g., service, office, and hotel sectors) as well as direct exposure to exploration and production firms."
Global Economic Downturn
Among the global credit issues of concern to regulators are the economic slowdown in China, and its impact on emerging markets around the globe, including the effect of decreased demand for commodities.
The OFR expressed concern that “the slowdown in China and the rest of the global economy is taking a toll on countries that export large amounts of commodities and capital goods for sale to Chinese businesses. … A third of U.S. corporate profits originate overseas. The stronger dollar and weaker global growth are dragging overall earnings lower. Total U.S. exposure from direct financial links between the United States and emerging markets, including U.S. investments in emerging markets and U.S. bank loans, is estimated to be $2 trillion to $3 trillion, or 1.1 percent to 1.6 percent of the financial assets in the U.S. private sector…."
The ECB, has expressed similar concerns:
Of particular concern is the outlook for China, given its growing role in the world economy. Turmoil in Chinese and other emerging market economies’ equity markets in August led to a strong and broad spillover around the world, including to the euro area.
The OFR is also concerned about the spillover effect of the slowdown in China on emerging markets as well as the US and other developed markets.
Many emerging markets have experienced a run-up in private-sector debt since the financial crisis, and they are facing a set of shocks to growth, financial flows, export prices, and confidence that make it challenging to manage their increased debt levels. In an adverse scenario, their situation could deteriorate in broad-based, severe economic and financial stress. China stands out, because of its importance to the global economy and the magnitude of its private debt overhang. In recent years, the United States has been notably resilient to recessions and financial stress in foreign markets, but a scenario of severe stress in China or broader emerging markets could affect the U.S. financial system, whether through direct financial linkages or confidence and second-round effects.
Emerging markets are facing a set of shocks: a substantial slowdown in Chinese and broader emerging market growth, the collapse in commodity export prices, depreciating currencies and financial outflows, and an array of political risks….
The OFR notes the sheer size of the debt overhang in emerging markets as adding to the problems caused by a global economic slowdown.
There is a sizable weak tail of emerging market firms, with outstanding debt having grown significantly since 2008. Among a sample of large emerging market countries, total corporate debt increased from $10 trillion to $24 trillion in 2008, raising some emerging markets’ corporate debt burdens significantly over the same period. Ratios of corporate debt to gross domestic product are now greater than 100 percent in China, South Korea, Thailand, and Chile.
Nonfinancial firms owe the bulk of the outstanding emerging market corporate debt (from 40 percent to 90 percent of total corporate debt across a sample of 16 large emerging markets). This segment also faces deteriorating fundamentals, including reduced profitability and balance sheet liquidity, increased leverage, and weaker debt-servicing capacity ratios. Brazil, Turkey, and China have the highest levels of gross nonfinancial corporate leverage among large emerging market countries, measured as the ratio of total debt to earnings before interest, taxes, depreciation, and amortization.
The OFR goes on to note that including both “U.S. investments in emerging markets and U.S. bank claims, total U.S. financial exposure is estimated at $2 trillion to $3 trillion, roughly half of which are debt claims."
The ECB, while sounding an optimistic note on the financial condition of European banks, has noted some of the same concerns with respect to European banks:
Euro area financial institutions have continued to make steady progress in strengthening their balance sheets and building up their resilience to adverse shocks. Nevertheless, they still face challenges relating to weak economic growth prospects, legacy issues from the financial crisis, and a strengthened regulatory and prudential environment.
Notwithstanding a recent improvement in euro area banks’ operating performance, finding sustainable sources of profitability remains a challenge in an environment of low nominal macroeconomic growth prospects and low interest rates across the maturity spectrum. Resolving a large stock of legacy problem assets also remains an issue, in particular in countries most affected by the financial crisis. Progress in removing non-performing loans (NPLs) from balance sheets remains moderate when measured against the stock of such loans, which remains an important obstacle to banks providing new credit to the real economy.
A recent Bloomberg article expressed less optimism on the state of European banks: “[w]hile American banks appear to have turned the corner since that gut-churning autumn nearly eight years ago, European institutions are girding yet again for another round of restructuring."
Thus, as concerning as the credit markets are within the United States, things are much worse abroad. As the OFR has reported:
Global growth has slowed and the strong dollar is dampening U.S. exports by making U.S. goods more expensive for foreign buyers. The dollar’s rise has also pushed down the prices of dollar-denominated commodities.
A key question, even for U.S. banks with no foreign credit exposures, is how the global economic slowdown will hurt the credit quality of domestic borrowers, through decreased commodity prices, lower exports, more price competition from imported goods, and other knock-on effects.
FASB Loan Loss Reserve Proposal
A potential wild card is the pending Financial Accounting Standards Board (FASB) and recently-adopted International Financial Accounting Standards Board (IASB) proposal on loan loss accounting for both US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The revisions to IFRS 9 have been adopted and are being implemented. The FASB proposal, which has been pending for several years, passed a major hurdle in December and appears to be moving towards adoption. The proposal requires banks to create a counter-asset at the time credit is extended to reflect expected loan losses based upon historical data and experience with similar types of credits. This accounting proposal, when implemented, will force banks to anticipate and recognize loan losses well before any sign of t-rouble in a particular loan or the loan portfolio. The counter-asset would be adjusted and updated over time based upon changes in the environment and experience with the loans and similar loans under current conditions. Adjustments to the counter-asset for anticipated loan losses might include changes to address developments in the economic environment or market of a particular borrower or lender, changes to underwriting standards and protective clauses in the loan agreement that affect default risk, and changes to the leverage and risk of a particular borrower over time.
The OCC observed that banks and regulators must pay close attention to “the appropriateness of allowance for loan and lease loss (ALLL) levels and methods given loan growth, easing in underwriting, and layering of credit risk." Historic loan loss experience is not predictive of future results, particularly when credit standards and clauses protective of lenders have eroded, the credit quality of borrowers has declined, and economic conditions have changed.
This renewed regulatory focus on credit quality and interest rate risk is not an aberration but a return to the norm. Credit quality, concentration, and interest rate risk are top priorities for bank regulators and their examination teams as the economy enters a period of great uncertainty in 2016. The potential impact of a slowing global economy, and the erosion of covenants and credit standards in the face of persistent low interest rates and competitive pressures, now have the full attention of the federal bank regulators.
Banks would be well advised to closely monitor and keep the board and senior management informed and engaged about developments affecting credit quality. Good current information, a well-functioning management information system, and clear lines of communication within the organization are crucial. Information about the condition of borrowers, developments in their markets, economic changes, credit market liquidity and depth, credit concentrations, and loosening of credit standards or loan terms and conditions, needs the attention and involvement of senior management and appropriate board committees.